1. Concept of borrowing costs and interest revenues (and economically equivalent)
The interest limitation rules, applicable as from tax years starting on or after 1 January 2019, provide for a limitation of the deductibility of taxpayers’ exceeding borrowing costs to 30% of the taxpayer’s tax EBITDA or EUR 3 million, whichever is higher.
Exceeding borrowing costs is a defined term and constitutes the difference between certain interest expenses and certain interest income. Borrowing costs are further defined by the law as interest expenses on all forms of debt, other costs economically equivalent to interest and expenses incurred in connection with the raising of finance.
The Circular provides some guidance on the concept of borrowing costs, especially those mentioned in the law. We have retained the following:
- Foreign exchange gains and losses which are in connection to interest only (and not to the principal) should qualify as borrowing costs;
- Amounts due on instruments available in the framework of Islamic finance should be treated as borrowing costs when they can be assimilated from a tax standpoint to a traditional financial instrument;
- An impairment on a loan shall not be considered as a borrowing cost;
- Costs incurred in relation to a mortgage or other guarantees on financing operations qualify as borrowing costs.
Article 168bis LITL does itself not define what constitutes “interest income and other economically equivalent income”. The Circular confirms that it should be defined or interpreted consistently and symmetrically by reference to the notion of borrowing costs. Consequently, if the amounts incurred are not considered as borrowing costs by the debtor, they should equally not be considered as interest income or other economically equivalent income by the beneficiary.
The Circular does not address the case of investments in distressed debt and whether the gain resulting from the difference between the amounts received from the debt and the initial acquisition price of the debt may or may not constitute an economically equivalent interest income.
The Circular also specifies the notion of tax EBITDA as it results from the wording of the definition inserted in Article 168bis LITL. In particular, the tax EBITDA does not include items of exempt income (such as dividends received from participations qualifying for the application of the participation exemption) and non-deductible expenses in connection with exempt income. The Circular provides certain illustrative examples on how the tax EBITDA is to be computed.
2. Precision on the application of the interest limitation rules
The interest limitation rules apply annually to each financial year. Consequently, a financial year which covers a period of less than 12 months is to be treated as a full financial year. Neither the 30% of the taxable EBITDA nor the EUR 3 million de minimis threshold should be prorated.
The Circular also clarifies that, in the case the Luxembourg taxpayer holds a participation in a tax transparent entity, the borrowing costs, the taxable interest income and the other income economically equivalent income are allocated to the taxpayer in proportion to the fraction held in this tax transparent entity. Similarly, the taxpayer should indicate the fraction of the depreciation of the tax transparent entity, as well as the deductions for depreciation made by the latter in its tax return.
The Circular also confirms that interest limitation rules are applied after application of other rules leading to a limitation on the deductibility of borrowing costs such as, among others, interest expenses in connection with exempt income or interest expenses covered by rules on hybrid mismatches Consequently, the interest limitation rules applies on the deductible borrowing costs.
The Circular clarifies interaction between the interest limitation rules and other rules such as the “recapture” included in the Luxembourg participation exemption on capital gains. The Circular states that only the borrowing costs that remain deductible have to be taken into account under the interest limitation rules.
Finally, in the context of a tax neutral transformation (notably merger, transformation,…), the carry forward of the exceeding borrowing costs and the unused interest capacity is not lost given that it should be continued in the hand of the transformed entity.
3. Exception to the regime
The interest limitation rules in principle exclude exceeding borrowing costs related to debt instruments entered into before 17 June 2016 provided such instruments have not be subsequently modified. Article 168bis LITL does not define “subsequent modifications” but the Circular provides for a list of amendments that are not considered as “subsequent modifications”.
- Amendments of the term and the interest rate of a loan after 17 June 2016, when such modification was contractually scheduled before 17 June 2016 and that it does not require the agreement of parties involved, but arises from the application of the loan;
- Drawdowns under an existing credit facility after 17 June 2016 in accordance with the terms and conditions contractually agreed before 17 June 2016; and
- Transfer to Luxembourg of the head office or central administration of an organization of a collective nature that is a party to a loan entered into before June 17, 2016 without any modification of loan conditions.
The Circular provides also for a list of amendments that are considered to be “subsequent modifications”:
- Amendments of the term and the interest rate of a loan after 17 June 2016, when such modification was not contractually scheduled before 17 June 2016;
- Amendment of the amount borrowed; and
- Modification of one or more of the parties concerned after 17 June 2016, when such a modification was not contractually provided for before 17 June 2016.
The Circular furthermore notes that a restructuring such as mergers or demergers do not alter the benefit of the grandfathering clause, while these transactions, as such, do not cause any change in the initial terms of the loan.
In case of a subsequent modification, the Circular states that the grandfathering rule should apply to the exceeding borrowing costs linked to the initial terms and conditions of the debt instrument, and the Article 168bis LITL should only apply to the exceeding borrowing costs deriving from the subsequent modification.
The Circular states that exceeding borrowing costs related to debt incurred to fund a long-term public infrastructure project in the EU are excluded from the interest limitation rules subject to certain conditions. In addition, any income derived from a long-term public infrastructure project is excluded from the fiscal EBITDA. It is therefore necessary to establish the fiscal EBITDA taking into account only the activities other than those implemented in the execution of a long-term public infrastructure project.
Finally, the Circular gives a definition of Financial undertakings that are excluded from the scope of Article 168bis LITL.
Standalone entities are also excluded from the scope of the interest limitation rules. The Circular states that standalone entity means a taxpayer that cumulatively meets the following conditions:
- It is not part of a consolidated group for financial accounting purposes;
- It has no associated enterprise (i.e., any entity or individual that is recognized as being an associated enterprise as per the definition used for purposes of the controlled foreign corporation rules); and
- It has no permanent establishment located in a jurisdiction other than Luxembourg.
The Circular clarifies that “associated enterprise” is not limited to entities in which the taxpayer holds a participation but refers to all entities that are covered by the relevant definition. The existence of a direct or indirect association between the taxpayer and an entity or a natural person should be analysed from an economic perspective.
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The Circular constitutes administrative guidance and in principle has a binding effect on the Luxembourg tax authorities and essentially forms an instruction on inspectors on how to interpret and apply the legal provisions covered by the Circular. However, taxpayers are generally not bound by clarifications given in circular letters. It is generally advisable to take note of the positions clarified in circular letters as a deviation therefrom may increase the risk on positions being challenged by the Luxembourg tax administration.
Taxpayers are generally recommended to review their financing position in light of this new guidance given and see how, if any, it may impact them.
Tiberghien Luxembourg remains committed to monitor the practical implementation of the interest limitation rules.
For any questions, please contact your trusted advisor at Tiberghien Luxembourg or contact any of the authors of this publication.
Michiel Boeren – Partner (michiel.boeren@tiberghien.com)
Gauthier Mary - Senior Associate (gauthier.mary@tiberghien.com)
Madeline Morel - Associate (madeline.morel@tiberghien.com)